This Week's Focus: Consequences of changing monetary cycle in USA

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Friday, 18 of December 2015

This Week's Focus: Consequences of changing monetary cycle in USA

The long-awaited rate hike Federal funds from the US central bank, the Fed finally arrived at its FOMC meeting last December 16 after more than six years of zero interest rates. The discount rate increased from 0% -0.25% range above 0.25% -0.50%.

The Fed reported that it expected to raise interest rates in the US money market gradually, four times in 2016 and four times in 2017. That is, he believes the official interest rate of the dollar will reach 2.5% end of 2017.

The market, however, does not discount such a rise and believes the Fed will take longer to normalize the levels of interest rates.

Is it good or bad for the American economy?

Picking the aspects highlighted Capital Group in its report "A gradual rise in interest rates", the apparent strength of the recent US economic growth (with GDP growth of 3.9% in the second quarter and unemployment 5.1% in August) contains the following points of interest:

• Signs of underlying weakness in the US economy. The participation rate in the labor force stands at 62.6%, thus recording its lowest level the last 38 years, meaning it has decreased the number of people working or looking for work. The wage growth and business investment has also been weak, and even job growth has fallen more than expected in recent months.

• The absence of inflation, largely due to falling energy prices, so the threat of inflation has almost disappeared. The index of personal consumption expenditures, the Fed's preferred indicator of inflation rose only 0.3% in the past year, significantly below the inflation target of 2% of the central bank. Even removing the prices of energy and food, the index rose only 1.3% yoy.

• The strong dollar. Throughout last year, the dollar has appreciated by 14% against a basket of global currencies, reaching in March its highest level in 12 years.

• The turbulence experienced by the markets around the world and geopolitical conflicts have scared investors, who have sought refuge in US Treasuries. Japan and China are two countries that invest in Treasury securities United States.

• The quantitative easing have spread worldwide. Although the Federal Reserve cut its bond purchase program in October 2014, the European Central Bank launched an ambitious expansion program.

Although the US economy shows little exposed to a slowdown in growth in China, the indirect effects of slower growth concern to the US monetary authorities.

The objectives of the Fed, full employment and stable inflation at 2%, are not far from being achieved, so that monetary policy should not lead to setbacks in the American economy as it did in the 90s.

How can affect the financial markets?

Rate expectations affect fixed income bonds and shares.

A fixed income, because the expectation of higher rates affect bond yields causing price declines. This reduction in price depends on the length of life of the bond, so longer term, the greater the drop in price.

However, not all the interest rate curve moves with rate hikes by the Fed. In the last year, the lower reaches 5 years if profitability have increased in line with expectations rise. The remaining sections, do not show that the market expects higher rates for long.

As for equities, the valuation of shares and at the end of the day, stock indexes, interest rate depends on the long term which expected future benefits are discounted. Thus, higher interest rate with equal benefits, means lower current rating and therefore lower path of a stock or index.

The theoretical valuation of the S & P 500 in the US stock market gives us that with the growth of the expected benefits to current interest rates, there is little or no route in this market unless corporate earnings grow more than expected one year sight.

Normally, corporate profits make up in the end of the economic cycle, which usually begin when monetary policy becomes more restrictive.

More volatility in sight

Uncertainty with us for a while as markets adapt to this adjustment and businesses deal with the end of the cycle in the US, which can even last two years in which we expect to continue raising rates. The effect on capital flows may have a more attractive return on fixed income today may put downward pressure on profitability of American equities, albeit in a limited way unless we start to see profit warnings in the coming season presentation of results that begin in mid-January.